The Euro Zone Must Act

The financial markets have been inundated with rumors that Brussels is about to make the euro zone's main bailout fund more effective. As the crisis that started in Greece and Ireland now threatens to overtake Portugal (Spain, Belgium, Italy…), it's evident that the European Financial Stability Fund (EFSF) has not performed as hoped for when it was created in May. European officials now appear to be moving toward a package that will reshape the EFSF into a fund which will achieve the stabilization of the current crisis. The Achilles heel of the fund has been known for some time: It is only when a country is at the point of drowning that a rescue takes place, by which time the next country in line is up to its neck in water. The condition that bailouts can only occur as a last resort has rendered the fund relatively helpless in preventing contagion.

One proposal now rumored to be under discussion would be to allow the use of the fund to preempt a crisis. This is said to be backed by a number of euro zone members, but Germany has apparently resisted up to now. The idea is to use the fund, perhaps in tandem with funds available from the International Monetary Fund, as a credit line to resist a self-fulfilling downward spiral. Such precautionary credit lines can be effective in providing the liquidity required to deter speculative attacks. However, some analysts say that if Spain and the other peripheral countries of the euro zone are facing a permanent retreat of their investors, most of which are elsewhere in the euro zone. If so, a preemptive credit may not be what is required.

Another suggested proposal is to let the bailout fund buy bonds issued by the countries experiencing difficulties. This idea should be supported by the European Central Bank, the reluctant (and sometimes surreptitious?) buyer of last resort in the euro zone's sovereign bond markets. Intervening early could prevent the upward spiral of bond yields, which sends the signal to the markets that a country's debt position is unsustainable, and closes off future market finance. This proposal is also imperfect as buying existing debt would reduce the amount of money which would otherwise be available for future financings.

The most promising possibility would be to lower the interest rates countries pay for the bailout funds. The current high interest rates were originally meant to punish irresponsible countries, but now these high interest rates are in danger of making the problems of the borrowing countries terminal, as they will not be able to bear costs of servicing their debts. Cutting interest rates for the bailout funds would be relatively easy; this would only require EU leaders to make a political decision. Most of the other proposals would require the leaders to return to their national parliaments to seek agreement and would, therefore, be tougher politically.

There is one other major issue which the member states need to address: the enlarging of the fund. Currently the fund uses government guarantees totaling EUR 440 billion, allowing it to issue EUR 255 billion of AAA bonds. This is supplemented by EUR 60 billion from another EU bailout fund and a contribution from the IMF of up to half of the Europeans' contribution. This would be more than enough to finance Portugal, should it need help. But it probably would not be able to cover Spain's requirements for the next three years given the precarious state of the capitalization of its banks.

Expanding the fund could be done in several ways. The guarantees of the EFSF could be amended to imply that every country was in effect guaranteeing all the bonds. This is understandably unpopular in the AAA countries and unlikely to get very far. Alternatively, the fund could issue its bonds with a lower rating, the result of utilizing guarantees from non-triple A-rated member states. But, as the EFSF has been marketed as a AAA credit, that would be viewed favorably by most European officials. The most straightforward solution would be an agreement to expand the size of the guarantees. To increase the EFSF's lending capacity to the current headline size of the fund, EUR 440 billion, would require more than EUR 700 billion in guarantees. Once again there is a potential drawback. A well-known analyst, Stephen Jen, has pointed out that if the EFSF is enlarged to EUR 700 billion or more, one or more of the currently AAA-rated government debts may be downgraded. A downgrade of any of the five triple-A countries in the euro zone — France, Germany, the Netherlands, Austria or Finland — would in turn compromise the credit ratings of EFSF bonds themselves. This is a scenario that European officials would probably dismiss. But the expansion of the bailout fund has to have a limit.

The lack of a common view about how to resolve the crisis is largely due to the insistence of several of the member countries that any increase in the EFSF can only occur if they can be assured of stronger policy coordination and financial discipline among the 17 euro zone member states in the future. It is very likely that some sort of compromise be achieved by the Eurozone's financial leadership that will allow greater use of the EFSF and at lower rates. It is obvious that with a growth rate of +/- 3.4 percent, short-term interest rates at 0.5 perfect are completely unacceptable for Germany's need to stem domestic inflationary pressure. So, in order not to hold back growth in the peripheral countries, which are either still in a recession or expected to go back into recession again soon, accommodative term financing at acceptable rates is an absolute necessity. Therefore any compromise will have to go in this direction; higher EUR interest rates but ample, low-rate, long-term financing available to the countries in trouble.

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The financial markets have been inundated with rumors that Brussels is about to make the euro zone's main bailout fund more effective. As the crisis that started in Greece and Ireland now threatens to overtake Portugal (Spain, Belgium, Italy…), it's evident that the European Financial Stability Fund (EFSF) has not performed as hoped for when it was created in May. European officials now appear to be moving toward a package that will reshape the EFSF into a fund which will achieve the stabilization of the current crisis. The Achilles heel of the fund has been known for some time: It is only when a country is at the point of drowning that a rescue takes place, by which time the next country in line is up to its neck in water. The condition that bailouts can only occur as a last resort has rendered the fund relatively helpless in preventing contagion.

One proposal now rumored to be under discussion would be to allow the use of the fund to preempt a crisis. This is said to be backed by a number of euro zone members, but Germany has apparently resisted up to now. The idea is to use the fund, perhaps in tandem with funds available from the International Monetary Fund, as a credit...Read More